Designers avoid risk, owners prefer to pass it along, and contractors absorb it. Today's construction risk environment is dramatically different than it was in the last several decades, and risk factors are mutating just enough to be almost unrecognizable. It is not enough to simply know in your gut that construction is a risky business. Most contractors I have known simply use intuition to evaluate whether they can complete a potential project successfully. They get a "feel" about a project and decide based on a lifetime of experience if they'll bid on it or not. They do not perform a formal financial risk analysis before deciding to take a job or pass on it.
Managing a construction business for profit, however, is a complex matter. It requires the recognition of various financial risks in as many as nine profit impact areas. As contracting companies evolve from small start-ups to medium size regional players, multiple financial risk factors combine to put downward pressure on the bottom line. Risk factors such as a shortage of skilled labor that slow the jobs down, or owners who delay payment at every turn and put pressure on cash flow. The time has come, and may be overdue, for all of us to embrace pre-bid risk evaluation head on. Some readers may say, not another thing we need to spend time on. Unfortunately, the answer is YES. In the modern construction industry pre-bid risk management is not just essential, it is critical. It takes an experienced CEO and a professional CFO to administer a formal risk management program to avoid setting off on project doomed to failure before the first shovel is put in the ground.
Until those responsible for risk management are able to recognize the multiple hidden risk factors in a project, they will not be able to estimate each risk factor's potential impact on project profitability. Nor will they be able to develop a mitigation plan for the overall risk profile of the project prior to signing the contract. In the current construction-business environment, a formal risk management approach is no longer optional but is essential if a contractor is to survive is such a complex business. This is particularly important in a volatile marketplace with a whole array of risk-taking competitors.
Financial Risk under Every Rock
These contractor financial risks are entwined and hidden under every rock in a construction project:
Nine Profit Impact Areas:
Availability of Skilled Labor
The Company's Growth Rate
Subcontractor risk
Capital Risk
Commodity Risk
Contract Risk
Change Risk
Accounts Receivable Risk
Innovation Risk
Looking Under Rocks
Sound financial management in the construction business begins with financial risk recognition, analysis, and mitigation.
Recognize hazards: Identify all the potential risks that could have a negative impact on your profits.
Analyze the risks: Once you identified the risks, the next step is to carefully evaluate them for probability of occurrence and grade them on the following scale:
1 = Rare
2 = Unlikely
3 = Possible
4 = Probable
5 = Almost Certain
Estimate severity of the risk: Estimate the possible profit damage or financial impact of each risk identified, then grade them on a scale:
1 = None or Slight
2 = Minimal
3 = Significant
4 = Major
5 = Catastrophic
This may seem like a lot of work but like all processes; the first time it takes a while to set up, but after that it is routine—just fill-in-the-blanks and evaluate. Our industry has gotten more complex and there are a lot of things we did not have to do in the past. The easiest way to increase profits is not to take losing projects. The easiest way not to take losing projects is to screen out losers before you take them. This process even saves you the time and effort of estimating projects that have “loser” written all over them but hidden under rocks.